4 Reasons to Think Twice Before Using a HELOC to Remodel Your Home

Just because you can tap your home equity for a loan doesn't mean it's the best move. 

When you're a homeowner, it's good to know you have equity in your home. If needed, you can tap into that equity to pay for important expenses. One way homeowners get cash from their property is through a home equity line of credit (HELOC). If you're considering a HELOC, this article is for you.

What is a HELOC?

A HELOC is similar to a credit card in one way: You have a revolving line of credit you can draw from as needed. There's a big difference, though. When you take out a credit card, it's typically unsecured, meaning you don't put anything of value on the line to secure the card. When you take out a HELOC, your home is used as collateral. That way, if you fail to make payments, the lender can repossess your home, sell it, and recoup its loss.

Whether you borrow money from your original mortgage lender or other financial institution, you'll normally be allowed to borrow between 80% to 85% of your home's value. Let's say your property is worth $300,000, and you're approved to borrow 80% of the home's value (which equals $240,000)

However, if you still owe money on the house, you must subtract that amount from the equity in your home. For example, if you still owed $80,000, the most you could borrow is $160,000 ($240,000 - $80,000 = $160,000). 

To be clear, a HELOC can be a wonderful source of cash for some people. For others, it's a risky proposition. Before taking out a HELOC, ask yourself the following questions.

1. Am I willing to put my home on the line?

Lenders are willing to approve HELOCs because the risks are so low. Your home acts as collateral and protects the lender from a total loss. 

It's up to you to determine whether a loan is worth the risk. For example, if you're taking out a loan to pay for a wedding, you have the option of downsizing the cost of the nuptials and paying cash. If you're in the mood to visit a tropical island in the middle of winter, putting your home at risk to do so may not make sense. 

Before signing on the dotted line of a HELOC, do a gut check. Make sure the money you're borrowing is worth the risk of losing your property to the lender. 

2. Am I prepared to deal with a variable rate?

Although it's not always the case, most HELOCs come with a variable rate that changes as the prime rate changes. While your interest rate may go down, it's important to remember that it can also rise, boosting your monthly payment amount. It's easy to get into trouble as the payment increases, and getting into trouble is the last thing you want to do when your home is on the line.

If you absolutely cannot abide the idea of a variable loan and you're looking for predictability, shop for a fixed-rate HELOC. That way, you remove any uncertainty about payments from the equation. 

3. What's my plan if my home loses value?

If you purchased property in the past two years or so, you may have bought at the height of the market, paying top dollar. Let's say that in the next couple of years the market is suddenly flooded with new housing inventory and the value of existing homes drop. Are you prepared to have even less equity in the home? 

While we can only guess at what will happen in the housing market, it's possible that some people who purchased their homes at the height of the market will find themselves underwater -- owing more on a property than it's worth. 

Are you prepared to be both underwater and owe money on a HELOC? 

4. Am I certain I won't need the equity in my home for another purpose? 

While it's important to have an emergency savings account with money to cover at least three to six months' worth of bills, home equity can come in handy when a true emergency strikes. For example, if you find yourself out of a job for months with no end in sight or there's a medical emergency in your family and it feels nearly impossible to cover the bills, are you okay with not having the backup of home equity from which to draw? 

No one can tell you with certainty whether it's right or wrong to borrow money from the equity in your home. However, if any of these four questions made you feel uncomfortable, it's worth exploring why.